In a year where many predicted that confidence would return to finance after the six-year lull brought about by the 2008 recession, a jarring story has emerged: the complete dearth of movement in forex investment.
Usually a market loved for its liquidity, foreign currency has been eerily quiet for much of the year so far. May was the least volatile month in forex for 25 years. Despite many commentators picking up on signs of life returning to the asset, July saw volatility drop to new lows once more, according to IG’s forex charts.
Average forex volatility across USD, JPY, AUD, EUR and GBP: 2008-Present
After the spike brought about by the 2008 crash, volatility has dwindled and despite 2013 proving an unexpectedly good year for forex, 2014 has seen a nosedive.
Is a trend that’s prevailed for almost six years about to turnaround? There are many reasons to believe that it might (more on that later), but in truth, predicting the future in forex is incredibly difficult.
However, looking at the past 20 years of forex volatility across major currencies – the US dollar (DXY), pound (GBY), euro (EUR), Australian dollar (AUD) and yen (JPY) – can offer a lot of insight into our current situation, and address some of the theories on what might end this lull.
3 month average forex volatility1994-present
The previous quietest year for forex volatility was 1996, whilst the highest came in 2008 – as a global financial crisis played havoc with the markets. Worryingly, the last time an extended period of calm occurred was for the 12-months leading up to 2008.
How has the market changed over the course of those peaks and troughs?
Average yearly volatility by major currency: 1996, 2008 & 2014
The biggest difference between 1996 and now is increased amount of volatility seen in the Australian dollar, which has taken precedent from the yen as the most volatile currency. The yen’s prominence would appear to be at odds with its profile as a ‘safe’ investment in times of trouble, whilst the dollar has taken an almost exactly even share of volatility (and always the lowest) for the last 18 years.
Whilst the amount of movement may have changed drastically since 2008, it is clear that it is spread in a very similar proportion. That makes sense, as the tight relationship between major currencies means that performance may scissor apart but volatility should remain broadly in line.
Yearly forex volatility by currency, 1994-14
Take a look at the broader picture, and the trend appears to have largely stuck in the years intervening 2008-14. 2013’s brief recovery in volatility, though, appears to have been driven largely by Japan (where Abenomics has been weakening the yen) and Australia (where the dollar fell dramatically over the year). Without them, a clear continual fall in forex movement would be even more starkly apparent.
The final point that becomes clear by looking at forex volatility as a 20-year trend is that, whilst we are on a broad six- year fall, it was only recently that movements dropped below levels that would have been considered normal before the recession. As such, traders can choose the extent to which this lull is alarming: as either a six-year drop or a single period beneath normal levels.
The most-cited factor dampening forex are the current low interest rates set by all the major central banks. The Reserve Bank of Australia, Bank of Japan, European Central Bank, Federal Reserve and Bank of England all have kept interest rates at record-lows for some time now. Of those, only Australia has interest rates above 1% (at 2.5%).
By keeping interest rates low, central banks stymie investment by ensuring that returns are kept at a minimum. The associated policy of quantitative easing also flooded major economies with cash, ironing out any unpredictability in currency.
The correlation between interest rates and currency volatility is not as clear in practice, however, which is demonstrated by Japan. Japan first adopted quantitative easing and low interest rates in an attempt to break the spiral of deflation their economy had become locked into. From 2001-06, interest rates were gradually reduced, first to near-zero and then to zero.
Overall, forex volatility was quashed for the yen during this period, down roughly a third when compared to the previous five years. It also saw some notable highs, however, and the yen’s previous biggest lull came as interest rates where at a relatively high 0.5%. Clearly, other factors were also influencing the movement of the yen.
Japan’s economy shouldn’t be taken as a lesson all on its own though. The Bank of England lowered interest rates – from 6% to 4% – in late 2001 and kept them at 4% or below up until 2004. Once again, although the drop in interest rates did lead to a 18% drop in volatility for the pound, the period with low interest rates also saw several volatility peaks.
Furthermore, the current steady-throttling of currency movement as interest rates remain low is not present for either period. Instead, life steadily returned to the pound after an initial curtailing from the drop in rates, with a similar picture seen in Japan.
Pound volatility during previous low interest rate period, 2001-2004.
Interest rates do suppress forex volatility, but not enough, it seems, to entirely explain the suffocating situation we are currently in.
For a better idea of where we have ended up (and where we might be headed), the picture must be widened. For many, interest rates will not remain at their current all-time low for long (in the UK, and US, at least) as many major economies look to be returning to form.
The steady return to prominence of major economies can lead to a suppression in currency movements: overall goodwill lessening the impact of major events and equalizing many currencies. It has also led to a boon for many indices and stocks, which have provided an enticing alternative to forex by posting huge growth.
Since 1990 we have seen three recessions: one largely confined to the US and EU in the early 2000s, a global recession in 1990-1993, and the one we are currently recovering from.
The previous period of forex calm – for a part of 1995 and 1996 in its entirety – came at a similar point after a global recession, as major economies were going beyond talk of recovery and into a period of sustained growth. It came, however, off of the back of a high point in forex volatility in 1995.
As for the early-2000s recession, it also saw a forex lull some years later as the US economy and indices hit previous highs. That period, however, resulted in the swift comedown of the Great Recession a little over a year later. Indeed, the last sustained fall in volatility was for the period preceding the 2008 crash as markets calmed from 2004-2007.
Not that this current period of sustained calm is any real indicator of an impending crash. Indeed, if anything the last 20 years have underlined the fact that forex is influenced by a multitude of factors, with no lone reason to blame for any major movements.
As such, relying on any single indicator of a return to life in forex – be it monetary policy, economic health or global affairs – is a risky strategy for any investor. The trend we are seeing at this point in time is unique, and will provide plenty of insight into the markets when viewed in hindsight. Until that point, it’s safe to assume that we cannot be entirely presumptuous about the state of forex volatility.
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